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The benefits of stress testing to mitigate risk

Stress testing can be a challenging exercise at the best of times. It’s technically complex, it’s time consuming and demands input from a broad range of stakeholders. And it’s a regulatory requirement for banks, fund managers, insurers, brokers and security houses. But you shouldn’t write it off as just a regulatory hoop to jump through.

Put simply, a stress test should put enough pressure on your business that the cracks begin to show. It should test what would happen under hypothetical adverse conditions, with the intention of understanding more about the weaknesses within your organisation. Most importantly, it can highlight areas of the business which have unidentified inter-dependencies which can create potential risk.

But the stress test itself isn’t enough. It’s about choosing the right scenarios and knowing how to use the results.

It’s all about imagination

Stress testing is essentially a pessimist’s playground. The more creative and catastrophic the scenario is, the more information you can glean about the business. Thinking outside the box like this can be difficult if market conditions have been stable for a long time, but it’s important to do so to really challenge the business. Consider what could go wrong both internally and across the market. What about your contingency plans? Are they dependent on third parties? Will they also be affected by a market or physical event?

How to use the results

Stress testing is about the output. But do you really know what to do with the information? If you find a major flaw, does the stress testing team have the seniority to address it? Is there a mechanism in place to support this? The results need to be fed back into the risk profile and used to inform broader risk management programmes – if this isn’t happening, what’s the point in doing the test to begin with?

With significant cross department input needed for the stress test, having senior oversight is vital. It can be difficult for stakeholders to see why their input is needed or what the benefit is. Senior sponsorship can help the stress testing team to obtain the necessary information and provide a platform to improve your controls.

Implementing change

Don’t forget the end goal. Stress testing is a forward looking exercise and should inform risk management processes across the firm. So what are you working on right now? How can stress testing help? How can it help with implementing the Fundamental Review of the Trading Book (FRTB)? How can it help to standardise counter-party and operational risk? Or can it inform your response to challenges around the Pillar 2a capital requirements? Viewing it as more than a regulatory exercise can help with all of these areas and maximise the value of testing.

For more information and advice on conducting successful stress testing, please contact Ian Morton.